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EBITDA Adjustments in Due Diligence: Categories, Pitfalls, and Best Practices

EBITDA adjustments in due diligence require clear categorization, source documentation, and defensible rationale. Here is how to get them right.

Datapack Team

EBITDA Adjustments in Due Diligence: Categories, Pitfalls, and Best Practices

EBITDA adjustments are the core output of a Quality of Earnings engagement. They transform reported earnings into a normalized, sustainable measure that buyers use to price a deal. The difference between reported and adjusted EBITDA can shift a purchase price by millions.

Getting adjustments right requires analytical rigor, clear documentation, and an understanding of how each adjustment will be scrutinized by the other side.

Adjustment Categories

EBITDA adjustments fall into three primary categories. Precise categorization matters because each type carries different weight in valuation discussions.

Normalizing Adjustments

These remove items that are non-recurring, unusual, or not representative of ongoing operations:

  • Litigation and settlements: Legal costs and settlements that are genuinely one-time. The bar is high. A company that settles a lawsuit every year does not have non-recurring legal costs.
  • Restructuring charges: Severance, facility closure costs, and reorganization expenses, provided the restructuring is complete.
  • Transaction costs: Advisory fees, legal costs, and management bonuses tied to the current transaction.
  • Natural disasters and insurance proceeds: Truly exceptional events with corresponding insurance recoveries.
  • Asset disposals: Gains or losses on sale of assets outside the ordinary course of business.

Pro Forma Adjustments

These reflect the ongoing impact of events that have already occurred or are certain to occur:

  • Acquisitions and dispositions: Annualizing the P&L impact of businesses acquired or divested during the analysis period.
  • New contracts or lost customers: Reflecting the full-year run-rate of significant revenue changes.
  • Headcount changes: Annualizing the cost impact of hires or terminations already completed.
  • Facility changes: Reflecting the run-rate of opened or closed locations.
  • Price increases: Reflecting contractual price changes already implemented.

Owner-Related Adjustments

Private companies frequently include items that would not exist under institutional ownership:

  • Above-market owner compensation: Normalizing owner salaries to market rates for equivalent roles.
  • Personal expenses: Vehicles, travel, insurance, and other costs benefiting the owner personally.
  • Related-party transactions: Rent, services, or purchases from entities controlled by the owner at non-market terms.
  • Family member employment: Compensation to family members performing no or limited functions.

Documentation Standards

Every adjustment must include:

  1. Description: What the item is and why it requires adjustment.
  2. Amount and period: The adjustment amount for each period in the analysis.
  3. Category: Normalizing, pro forma, or owner-related.
  4. Source: The specific GL entries, invoices, or other documentation supporting the amount.
  5. Rationale: Why this item is not representative of ongoing operations.

Strong audit trails are non-negotiable. A PE partner reviewing the QoE will want to trace any adjustment back to its source data. If they cannot do this quickly, the entire report loses credibility.

Common Pitfalls

Kitchen Sink Adjustments

Adding every conceivable adjustment inflates adjusted EBITDA and erodes trust. A QoE with 30 adjustments totaling 40 percent of reported EBITDA will be scrutinized heavily. Focus on material items and be prepared to defend each one.

Asymmetric Adjustments

Adjusting for one-time costs without adjusting for one-time revenues is a red flag. If a legal settlement cost is removed, the corresponding insurance recovery should be as well. Buyers and their advisors will catch asymmetries.

Recurring "Non-Recurring" Items

The most common criticism of QoE adjustments is that the "non-recurring" items recur. If restructuring charges appear in 3 of the last 4 years, they are a cost of doing business, not a one-time item. Apply the standard rigorously.

Unsupported Management Adjustments

On sell-side engagements, management often proposes adjustments that the TS team must evaluate. Management adjustments require the same level of scrutiny and documentation as analyst-identified items. Accepting them without independent verification is a quality risk.

Missing Run-Rate Impact

Pro forma adjustments must reflect the full run-rate, not just the stub period. If a facility closed in month 8, the cost savings adjustment should reflect 12 months of savings, not 4.

The EBITDA Bridge

The adjustment summary is typically presented as an EBITDA bridge:

  1. Start with reported EBITDA
  2. Add normalizing adjustments (with subtotals)
  3. Add pro forma adjustments (with subtotals)
  4. Add owner-related adjustments (with subtotals)
  5. Arrive at adjusted EBITDA

Each step should be traceable. The underlying data preparation must support drill-down from the bridge to the GL detail.

Technology Support

The manual process of identifying, categorizing, and documenting EBITDA adjustments is inherently analyst-driven. However, the supporting workflow benefits significantly from automation:

  • Automated GL mapping ensures every account is correctly classified, so adjustments are identified against a clean baseline.
  • Anomaly detection highlights unusual items that may warrant investigation.
  • Adjustment templates standardize documentation across engagements.
  • Audit trail tools link each adjustment to its source data automatically.

The goal is not to automate adjustment identification. It is to automate everything around it so the analyst can focus on the judgment calls that define the quality of the QoE deliverable.